Taking Aim at Target Prices

Projecting a Stock’s Short-Term Movement

What would make investing a whole lot easier? How about knowing what the price of a particular stock will be next year at this time? In fact, a target price — the anticipated price of a stock at a certain point in the future — is one of the projections equity analysts typically make in evaluating the potential performance of a particular stock.

An equity analyst’s job is to forecast the future performance, including share price, of a number of stocks within a particular sector or industry. His or her conclusions are based on company fundamentals reported in public documents, including the 10-K, the 10-Q and proxy statements; corporate websites; conference calls with company managers; firsthand observations and interviews; and often proprietary software that crunches data to spot trends and provide valuations. In addition, the analyst considers the domestic and global environment in which the company operates and its competitive standing among peers.

An analyst’s focus tends to be relatively short term — typically 12 months, with quarterly updates — though it can sometimes be as long as 18 months. An exception is the independent research firm Value Line, which uses a time frame of three to five years.

The analyst’s report, which is typically supported by a narrative and top-line summary of the relevant information, often has projections of several important financial measures. These include earnings per share, a forward price-earnings ratio — in which the earnings often are based on the most recent two quarters of earnings and projections of the next two quarters of earnings, or on a forecast of the next four quarters of EPS — and the target price. The analyst may also provide an explicit recommendation to buy, hold or sell a stock, sometimes couching the recommendation more ambiguously in terms such as overweight or underweight.

Calculating the Price

Although short-term target prices aren’t of great significance in your stock studies, you’ll often come across them in your research. A target price is typically calculated by multiplying the earnings estimate times the P/E, which seems extremely straightforward. If the EPS estimate is $0.95 and the P/E is 24, the target price would be $22.80. If the price is $17.50 now, that makes the stock seem like a good buy.

But there are two issues to think about. Earnings estimates are based on the analyst’s projections, which in turn are derived from the available hard data and what company executives have to say in conference calls. But earnings can be framed — quite legitimately — in a number of ways, and the company may be presenting its past and projected results in the best possible light. What’s more, there’s evidence to suggest that both corporate and analyst earnings estimates tend to be optimistic.

The second concern is that a forward P/E is also a projection rather than hard data. In an attempt to provide more grounding in reality, some analysts use a P/E they consider appropriate for a particular company based on its historical record. Others use a P/E characteristic of the company’s industry.

Some analysts also incorporate other elements in their price projections. For example, they may look at a stock’s beta to account for historical price volatility or take a broader, more global view of the market environment.

Perspectives on Price Targets

Target prices generally get bad press and are often lumped with buy-sell recommendations as opinion it’s best to ignore in an analyst’s report. And this criticism isn’t leveled only at sell-side analysts who work for brokerage firms and investment banks. There’s no evidence that the target prices of analysts at independent firms are more accurate.

At the same time, there’s widespread agreement on the importance of having a stock’s potential future price in mind when determining the appropriate time to buy a stock. You need this estimate to understand the risk and reward of owning the stock.

Some independent analysts, including those at research firms Morningstar and Standard & Poor’s, evaluate discounted free cash flows rather than current or projected earnings to form a view of a company’s prospects. In calculating the company’s so-called fair market value, these analysts may conduct comparative studies of an entire industry to put a company’s value in perspective. They may also reach their conclusions based on the combined value of a company’s core businesses.

Fair market value and your own research on a company are likely to be more useful in building your long-term portfolio than the short-term projection of a target price — whether or not it turns out to be accurate.